The contemporary low volatility trading environment has been kind to actively managed equity funds - particularly if they piled into large-cap momentum stocks like Facebook and Amazon, which have been responsible for the bulk of this year’s rally.
But while active managers have enjoyed three quarters of strong returns, quant funds – purportedly the future of asset management, according to many an “expert” on Wall Street – are falling further and further behind. As Bloomberg reports, during the first nine months of 2017, the average equity fund was up 9.7 percent while quant funds rose only 0.6 percent, according to data from Hedge Fund Research.
The striking reversal has validated the views of the handful of quant-fund skeptics on Wall Street, many of whom were previously branded as “luddites” for questioning the inherent superiority of algorithm-driven investment strategies. Quant funds, as we are learning, don’t function well in a low volatility environment because there are fewer opportunities to exploit small disparities in price.
The environment that lifts stock pickers - steady markets that enable their long-term trades - is not so friendly to quants. They do best in periods of volatility and dispersion, when their algorithms can find small price disparities to exploit. But the U.S. stock market has been unusually tranquil since last year’s presidential race. At an average level of 11.6 since Election Day, the CBOE Volatility Index has hovered about 40 percent below its lifetime average.
“To a certain extent they are lowly correlated," Tim Ng, chief investment officer of Clearbrook Global Advisors, said of the two strategies. “The factors that drive positive returns in each are different, so what helps one doesn’t necessarily help another.” His firm invests in hedge funds.
Despite their recent underperformance, quant funds have continued to receive the bulk of hedge fund inflows. Last year, total hedge fund assets AUM dropped for the first time in years as investors pulled money from actively managed funds and reallocated to both passive and quantitative strategies.
Still, both quant funds and traditional discretionary managers have on average continued to underperform the S&P 500.
Equity funds betting on technology have posted some of the biggest gains in the first three quarters. Light Street Capital Management’s Halogen fund, which focuses on technology, media and telecommunications stocks, soared 44 percent, said a person familiar with the matter. The flagship fund at Philippe Laffont’s tech-focused Coatue Management jumped almost 24 percent, according to an investor letter seen by Bloomberg News.
Computer-driven funds struggled to keep pace in the period. BlueTrend, the main fund at Leda Braga’s Systematica Investments, dropped almost 7 percent, another person said. The Diversified fund at $6.6 billion Aspect Capital fell 4.7 percent, according to an investor letter seen by Bloomberg News. Winton Group’s Futures fund is about flat on the year, according to a person with knowledge of the returns.
While the hedge fund industry’s overall performance is improving, it still lags behind the S&P 500 Index, which was up 14.2 percent with reinvested dividends this year through September. Funds across all strategies on average returned 4.3 percent on an asset-weighted basis in the period, compared with 0.7 percent in the first nine months of last year, according to Hedge Fund Research.
As we noted above, funds focusing on tech stocks have posted some of this year's biggest gains:
Equity funds betting on technology have posted some of the biggest gains in the first three quarters. Light Street Capital Management’s Halogen fund, which focuses on technology, media and telecommunications stocks, soared 44 percent, said a person familiar with the matter. The flagship fund at Philippe Laffont’s tech-focused Coatue Management jumped almost 24 percent, according to an investor letter seen by Bloomberg News.
And to be sure, not all quant funds have had a bad year. Bloomberg managed to find one that’s up 53%.
Not all quants have had a bad year. The QIM Tactical Aggressive Fund gained 53 percent in the first nine months, according to a letter seen by Bloomberg. Nor have all traditional stock pickers done well. Crispin Odey, who is known for his bearish bets, saw his European equity fund sink 14 percent this year through Sept. 15 in its U.S. dollar share class.
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After Eagle’s View Asset Management, a $500 million fund-of-funds that invests with 30 managers, half of them quants, recorded its worst monthly performance ever in June, the fund’s manager Neal Berger penned a letter to clients explaining why quant strategies have broken down over the past year.
It comes down to two factors, he said:
1.Increased competition: more investors are using algorithms to fight over the same inefficiencies in the market.
“Now every bank has a factor model,” said Benjamin Dunn, president of the portfolio consulting practice at Alpha Theory LLC, which works with managers overseeing about $200 billion.
“You’ve had a democratization of a lot of data and analytics that were once the domain of very systematic quant investors. Everything is getting arbitraged away.”
2. Low volatility: quantitative funds are most successful in an environment where there is large disagreements in the market over the prices of assets. Today there is little disagreement, and the best way to earn outsized returns is placed highly leveraged bets that the market will remain calm. That's working for some investors, but is far too risky for others.
In fact, the persistently low level of volatility has brought out an increasing number of hedge funds strategies oriented toward regularly selling volatility. Although we believe that this is "picking up nickels in front of a bulldozer", shockingly, these Funds have been some of the best performing strategies over the past years.
Although our guess is as good as anyone's, we believe the shockingly low levels of volatility has to do with an increase in computer driven, quantitative trading coupled with banks selling options to offer "yield enhancement" structured products to investors who are starving for this yield.
This feedback loop, the increase in assets run by hedge funds, and, the rise of quants, has created unusual patterns, dislocations, and low levels of volatility.
While those simply following the broader market indices wouldn't realize anything is amiss, it is our belief that these factors have created a challenging mix for trading oriented strategies. It won't last forever, but, it could last longer than we can.
Additionally, he explains, systematic strategies require an endless supply of victims to thrive, and the growth of quant and passive funds has caused dumb money to behave unpredictably or disappear altogether.
With all the geniuses in quant, high-powered computers, and enormous data, where are the "suckers" who are providing the juice for all of these absolute return quantitative strategies?
Simply put, the 'edge providers' have moved aggressively into passive index funds and broader market ETFs.
As such, we have a condition amongst the traditional quantitative strategies whereby we have robots trading against robots. Without a steady source of 'edge providers', these 'edge demanders' are just trading money back and forth with each other.
We believe increased quantitative trading coupled with passive indexation by retail, and, low levels of realized and implied volatility may be creating a feedback loop that has caused unusual price movements in a variety of securities that have challenged trading oriented strategies.
Of course, all of this could change shortly as market strategists like Bank of America’s Michael Hartnett warn that a sharp selloff could be in store for the fourth quarter. Investors have upped their bullish bets through S&P 500 calls, buying more S&P 500 delta over the past two weeks than at any point since 2007.
In summarizing the contemporary market, Hartnett explains that the "best reason to be bearish in Q4 is there is no reason to be bearish.”
Complacent active managers ought to keep this in mind.